Presenting A Scientific Theory For The Fair Value Of Gold (With 88% Accuracy)

The greatest mystery in finance is and always will be what the fair value of gold is. Unlike stocks, where fair valuations are usually based on some multiple of cash income, earnings, or dividends, gold has no inherent dividend, nor a positive carry, and thus value is confined the realm of the intangible. Some pundits have considered the fair value for gold a price which covers the currency in circulation in a given country on a dollar for dollar basis. Others attribute a floating valuation to gold such that is convertible to any asset at a specific ratio, to account for inflation over the ages. Yet others dismiss any valuation attempts outright as hogwash, claiming that gold has any value to it solely due to insane and deluded gold bugs manipulating the gold market ever higher, contrary to the earnest attempts of shorters such as a JP Morgan and Sempra who are merely trying to keep gold priced as fairly (i.e., closely to zero) as possible. Due to the various (and numerous) conflicting opinions, we read the following paper from University of Albany professors Faugère and Van Erlach "The price of gold: a global required yield theory" closely. In it the authors observe that gold is priced to yield a constant after-tax real return related to long-term productivity as defined by real long-term GDP/capita growth.

While we sincerely recommend that anyone who has even a passing interest in gold read the paper in its entirety, we present the key sections.

Assessing the fair value of gold largely remains a mystery in Finance. While in some instances the existing literature has found empirical relationships between gold prices and macroeconomic variables such as inflation and exchange rates, little evidence has been offered for connections between gold and other asset classes. To date, there is no comprehensive theory of gold valuation showing how inflation, exchange rates and other asset classes may together affect gold pricing; or how gold and other asset classes may be affected by common underlying factors.

In this paper, we offer a gold asset pricing theory that treats gold as a store of wealth. We demonstrate a theoretical and empirical link between gold price, inflation, and foreign exchange rates and the general valuation of the stock market. Our approach is based on a generalization of Required Yield Theory (Faugere-Van Erlach [2003]). Required Yield Theory explains the valuation of financial assets via investors’ general requirement to earn a minimum expected after-tax real return equal to long-term GDP/capita growth.

We hold that since gold fulfills the unique function of a global store of value, its yield must vary inversely to the yield required by any financial asset class, thus providing a hedge in the case where such assets are losing value. Our theory explains about 88% of actual $USD gold prices and 92% of actual gold returns on a quarterly basis, including the peak prices of gold, over the 1979-2002 period.

The extant literature has well documented empirical relationships between gold price and global macroeconomic variables such as inflation and currency exchange rates. For example, Sjaastad and Scacciavillani [1996] show that after excluding the sharp rise in gold prices in the early 1980’s, about half of the variance in $USD gold prices during the period 1982-1990 appears to be accounted for by fluctuation in real exchange rates. Ghosh, Levin et al. [2002] find that gold is mostly an inflation hedge in the long run. They further attempt to justify short-term gold price volatility by appealing for example to changes in the real interest rate and $USD vs. rest of the world exchange rates fluctuations.

On the other hand, the empirical record weighs heavily on the side that gold pricing apparently is related neither to GDP growth nor to other asset classes. Lawrence [2003] concludes that there is no statistically significant correlation between real returns on gold and changes in macroeconomic variables such as GDP, inflation and interest rates, and that the return on gold is less correlated with returns on equity and bond indices than are the returns of other commodities. Standing in contrast to the above findings, Coyne [1976] focuses primarily on gold as a hedging instrument and finds that for periods in which the gold market was free to fluctuate, gold tended to move in a direction opposite to the price of other financial assets.

Sherman [1983] makes a noted theoretical attempt at demystifying the pricing of gold. He uses a linear regression model to estimate elasticities of demand for gold. The key explanatory factors are exchange rates and unanticipated inflation proxies. While several useful relationships are studied, these relationships are assumed a-priori and not theoretically derived.

Barsky and Summers [1988] focus on the Gold Standard period and develop a general gold valuation model that views gold as a non-monetary durable good providing a stream of “consumption” services over time, like Jewelry or objects of art. They theoretically show a relationship between the inverse of the log of gold price and the real interest rate, which seems to hold empirically over the period 1974-1984. In their model, gold is a non-depreciable asset earning a yield equal to a government bond yield.

However, by rooting their model in the Gold Standard era, and extending their approach to the current era, they are not addressing the nature of Gold as a store of value, that is, a hedging instrument against inflation and the collapse of the value of other asset classes. In this paper, on the other hand, we undertake the analysis of gold along this exact line.

A brief overview of the proposed Required Yield Theory.

Throughout the history of civilization, gold has been the single most important global store of value. To this day, it fulfills this unique function. For the purpose of extending Required Yield Theory to gold pricing, we postulate the following: 1) The global real price of gold essentially is a real P/E ratio for gold, where “earnings” represent purchasing power or a global price index. 2) The global real price of gold must vary inversely to all other main financial asset classes’ real P/E to preserve the real value of any investor’s capital against adverse movements in the values of financial asset classes.2 3) Law of One Price: exchange rate fluctuations must impact local currency-denominated gold prices to eliminate potential international gold arbitrages. 4) Mining supply must be stable in relation to supply movements in the aboveground stock and the worldwide stock of gold per capita should not increase in the long run.

Condition 1) recognizes that even though gold does not produce actual earnings, its primary purpose is to provide a stream of services by maintaining real purchasing power over time. The same unit of gold can serve to purchase a representative basket of economic goods repeatedly. We define the forward P/E for gold as the price of gold divided by expected next period’s GDP deflator. It is easy to check that the real price of gold is the same as the real forward gold P/E ratio.3 Condition 2) insures that gold behaves as a store of value, that is: capital flows to gold are dictated by changes in the minimum expected return achievable by other asset classes. It is important to emphasize that gold per-se does not require the same yield as other assets, as it stands outside of the conventional realm of investment goals, and acts mostly as a global hedging tool against financial downturns, and inflation.

Hence, our theory postulates that movements in the global real price occur because of the precautionary demand for gold, which largely depends on changes in the inverse real P/E (or required yield) of other assets classes combined. A consequence of this postulate is that a decline in the value of the stock market index does not necessarily entail flight to gold when, for example, expected stock earnings are also falling to maintain a constant real P/E ratio. On the other hand, flight to gold will happen when stock market prices are dropping faster than expected earnings due to acceleration of inflation for example.

In addition, since gold is a global homogenous durable commodity its price must be equalized across countries after currency conversion, which is stated in condition 3). Finally, condition 4) states that the supply of gold must be stable so that investors’ precautionary motive is fulfilled without major price movements driven by supply shocks. Indeed this condition seems to be characteristic of the precious metal mining industry. Later on, we provide a formal argument that shows that this must be the case under our theory.

The authors provide the following useful brief overview of the gold market (obviously the price/oz is as of the paper's writing ca. 2005. The current price is approximately 3x the $380/oz used in this calculation):

The total aboveground value of gold in the world is currently around $1.9 trillion at $380/Troy oz. ($380/Toz. x 32,150.7 Toz./Metric ton x 155,000 Mtons) compared with the approximately $15 trillion value of the US stock market and $22.4 trillion for US non-financial debt outstanding. Gold mining is a $31 billion per year industry with gold prices at $380/Toz. Given that the price volatility of gold is around 10% per year, it is easy to see why production companies heavily engage in hedging their future production. Ibbotson, Siegel and Love [1985] estimated that gold bullion represented 5% of total investable world wealth. Today, total world gold bullion represents 5.1% of the combined US stock and bond capitalization of $37.4 trillion; and a thus a much smaller proportion of total world wealth than the Ibbotson et al. study.

The rate of growth of gold extraction has essentially matched world population growth over the past 30 years. IMF data show that the more developed nations’ population grew a compounded 1.45% from 1972 – 2002, while total world population grew a compounded 1.89%. The global accumulated stock of gold grew from an estimated 98,000 tons in 1974 to 145,000 tons by mid-2001; implying a 1.46% growth rate. Thus, the world stock of gold per-capita has remained relatively stable over this period.

A preliminary empirical investigation of the price of gold reveals a non-trivial connection between real gold prices and the US stock market. Figure 1 below shows that gold’s real price varies inversely to the S&P 500 P/E, and thus with the earnings-to-price ratio. Figure 1 shows the high correlation between indexed USD real gold prices, inverse S&P 500 forward P/E ratio and 10-year T-Bond, over the period 1979-2002.

The theory we develop below predicts and explains this high level of correlation based on viewing gold as a global store of value.

Cutting to the conclusion, it appears that the authors' theory provides a valid basis for extrapolating gold prices, beyond mere voodoo and predicting prices based on cow manure patterns.

We have extended the Required Yield Theory (RYT) developed by Faugere-Van Erlach [2003] to value gold and to determine its return. RYT states that since global assets are priced to yield a global constant real return, and since gold is a global store of value, its price will vary directly with the global required yield and the global inflation rate. In the course of developing this asset valuation model we introduced a new exchange rule parity based on required yields comparisons across countries.

Specific predictions include: 1) the real price of gold varies proportionately to the change in long-term economic productivity as measured by GDP/capita growth. 2) Real gold prices vary proportionately to changes in the foreign exchange rate (direct quotation) when the domestic required yield is constant. 3) When the foreign exchange rate is constant and there are no major geopolitical or natural crises, real domestic gold price increases with domestic inflation. 4) When our new exchange rate parity rule holds, then effectively the real domestic price of gold is mostly determined by the domestic required yield. This entails that foreign exchange effects will impact the domestic real gold price to the extent that equalization of required yields is not taking place worldwide and/or that PPP is violated as well. 5) In the long-term, the gold per-capita supply remains constant. 6) The average long-term absolute price of gold is marked-up cost where the profit margin is given by the global average long-term per-capita rate of GDP growth.

While we suspect that central bank activities, hedging activities, supply/demand fluctuations, global real GDP growth changes or changes in global income and capital gains tax rates, affect gold prices as well, the valuation approach developed here performs very well absent these factors, with over 92% accuracy in predicting US Gold returns over a 23-year period. We leave an investigation of the role of these other factors for future research.

As for the practical implications of these findings:

In the long run, the gold mining industry’s real profit margin is constant and equals the real per capita productivity. The price of gold, on average, must be the average production cost plus a constant mark-up. Furthermore, in order for the real value of gold to be maintained on a per investor basis, the stock of gold has to grow at a rate that can be no greater than population growth in the long-term. If the supply of gold grew at a lesser rate than population growth for reasons other than depletion of the exhaustible ore, gold price would grow faster than inflation and the quantity demanded for gold would drop. Eventually the supply of mined gold will dwindle, which will drive prices up unless world population experiences zero growth in the foreseeable future. In that circumstance, far off in the future, a substitute medium of storing value may be discovered and used.

Another prediction of our theory of gold pricing is that the decrease in proportion of gold total value as compared to world wealth is explained by RYT in the fact that relative to financial assets, the long-term nominal value of gold must increase at the inflation rate, whereas the value of other assets rise with inflation plus real productivity. Thus, the proportion of investable wealth declines at an annual rate equal to real per share earnings growth or GDP/capita growth.

While we are certain that this paper's findings will not even bring the massive divide between gold fans and pessimists even an inch closer, having a solid, reproducible basis in which to reproduce the authors' results could be sufficient for some crazy quant to put together a HFT algo which will trade gold based on the postulates presented herein. And with an 88% prediction rate (absent major outliers events), we are confident that this could be an appropriate problem to reverse engineer (if it hasn't been already).

Gold is a hedge against devaluation and deflation and other instabilities, not so much inflation. Gold is money, USD is a derivate. Since -71 it is not even connected to its underlying asset. It is amazing.
A collapsing currency is deflationary i nominal terms (Island) and always in real terms (Island, Zimbabwe). You think deflation is always good for the value of the currency? It is not. Can you give one example in history, where debt deflation/bankruptcy increased the value of the currency (to gold)?
Any country with a printing press will print.

Good paper. It points out that what we think of a dollar (a single paper dollar bill) is not a dollar. I think Greenspan once said that a dollar is 100 cents.

The correct price of dollar (beyond what somebody is willing to pay) is hard to determine.

What is easy to determine is the general trend in valuation of fiat currencies. To do this choose your relevant time period (1 year, 10 years, 100 years) and consider that currency's ability to purchase a basket of goods and services that matter to you (food, shelter, fuel, medical care, education,...)

Another method of trend valuation is consider if trust in the printing authority (Federal Reserve) is rising or falling and whether there is any reason for that trend to change.

"Toto, we're not in Kansas anymore, and that man behind the curtain seems venal."

Hey, pslater, if you do run some spreadsheets (checking correlations between 2005 and now for example), please advise the ZH community, in this thread or the next convenient gold thread.

The paper is way too dense to plough through on a Friday night for me, the math alone will take me sometime to digest.

Still, if the authors are right, this is an important set of knowledge for those of us who like gold.

Gold...Bitches said fair value is about to increase substantially. I agree. If fair value goes up like FOFOA thinks, then, well, the authors may have gotten it all wrong. Or maybe not, I will have to read the paper to better judge their conclusions.

Well, do you feel as if there is new knowledge in this article? Much of it falls back on common sense once you have the field data to form an opinion with some backing. The market value of gold has "a non-trivial connection between real gold prices and the US stock market," which bases itself on its dependence on an established trading system. Trying to find the lurking variables that it is dependent upon is the trick. Dependence hides when the bubble grows because the system's strength drives away the need to look for connected ties between parallel industries. It changes with the entrance of weakness in a sector of the market and the shifting investment wealth (buying frenzies, HFT, apocalypse-worshippers) overload one sector and bring the dependence/independence of it into focus.

Also, I don't think people appreciate the workings of crisis when they aren't happening. Gold has been rising the last decade but everything else lost its appeal in the later half of this blessed millennium.

As a part of the younger generations, I'll hold a grudge to those in the US who blew the chances of a superpower and mourn the patriots who gave us a missed chance.

This is why I love and hate ZH. Here I was all set to turn off the brain for a bit and go watch some of the Olympics on tee vee, and now I'm going to have to read this paper. Actually I think it's mostly ice dancing tonight so maybe not so much of a loss...

The supply of tokens is limited by computing power which in turn is limited by the cost of electricity which in turn is limited by energy production. It's designed so that new tokens require more computing power to create and annual production is actually declining. Given enough time, as the pool gets disproportionally larger and as annual production drops, the supply will be nearly constant. It's hard to know which design of digital currency, all in experimental stage, will ultimately be chosen, if ever, by the Market in the future.

Before precious metal, humanity has used seashells, tea leaves, and feathers as a store of value. Now, some people use wine and cigarettes. I won't be surprise if future economies used abstract mathematics as a store of value and the Market is priced as such. Economists will need to write a paper on the fair value of cryptographic hashes, prime numbers, elliptic curves, etc.

I like to price gold against gasoline for a rough idea of whether gold is cheap or dear. In 1960 gasoline was about 30cents a gallon and gold was $35 per ounce, so it took about .0086oz of gold for the gallon of gas. Now it takes about .0027oz for the gallon.

That's a good one. I read somewhere that an ounce of gold, ever since Roman times, would buy one a good suit, belt and shoes. Nothing too extravagant, but good enough stuff. Again, an attempt to quantify the price in terms one can readily grasp.

I expect an ounce to be more valuable than your comparison now, i.e. maybe 1/4 or 1/10 ounce for the same garb. The reason is there are far more people around now such that the amount of all mined gold yields about 1 oz per person globally, and additionally you would need to considered that large amounts of said gold is held out of circulation by central banks. I've been thinking of many different metrics for the worth of gold. Another comparison I've thought about is what price of gold would be required to balance the Federal Reserve's balance sheet after applying an appropriately marked down valuation to the assets on the Fed's balance sheet, including an interest rate for Treasuries I think more appropriate given the deficit problems, so that assets equal liabilities (the Fed's liability side consists of cash). One can come up with all kinds of different prices.

Maybe. But the argument gets into the whole "is gold money" predicament. At 1 oz/person if gold is the only real money (which I realize it probably isn't), you are saying that the entirety of a persons wealth, on average, will only buy a suit. I was implying that a fair value of gold is higher than its current price around $1100.

Here's more food for thought. The U.S. has 262 million oz of gold worth $292 billiion at today's market price. That gold is the country's accumulation of wealth through its entire history. This years deficit at ~$1.5 trillion is ~5.1 times its entire gold supply. Last year was about the same. By printing (debt-backed) money in the fashion we are, we claim to produce 5x the wealth (in gold) accumulated in 222 years, every year. Which money has more value?

Hansel: The U.S. has 262 million oz of gold worth $292 billiion(sp) at today's market price. That gold is the country's accumulation of wealth through its entire history. This years deficit at ~$1.5 trillion is ~5.1 times its entire gold supply.

Me: Give me your house and car and I promise you your wealth won't drop. Thank you in advance.

Hansel: If you give me some gold in return.

You didn't catch my point did you? There's more to wealth than the accumulation of gold. To calculate a deficit to gold ratio and think you've done anything of any real significance is the dumbest fucking idea ever.

Clown, do you think of your wealth as 1 house and 1 car, or as a house worth $XXXXX dollars and a car worth $XXXXX dollars? I'll put words in your mouth and say yes, but those things are only worth what you can sell them for. Enter money. If U.S. dollars aren't money and gold is, see my prior posts. Mental midget.

I agree that the undistorted value of gold is going to be way more than $1100 (today's equivalent). I think the entirety of a person's wealth is not represented by the amount of money they hold though...unless you expand the word 'money' to mean anything that has a value...which would be impractical.

If you're still reading... People currently measure their wealth in dollars. Their house isn't money, but they think of it in terms of how much they they can sell it for, so it would seem a country's assets are backed by the country's available money. A 1:1 price of assets to money probably is unrealistic because all assets won't be sold simultaneously. But the ratio of money to assets implies a certain amount of leverage in the system, and I don't know what that ratio should be. In a capitulation event, for instance when a large number of people are foreclosed and need to sell at the same time, the leverage ratio will move towards a 1:1 ratio. From what level it comes down, I don't know.

I like that line of thought. And, ok, I get the whole suit thing, but tend look @ it in another light. I'm inclined to wit that the price of Au does not fluctuate at all, that's the biggest lie in finance I've seen, yet. Fiat is measured by the precious. Manipulation be damned at some point, it is not a god infallible to such coordinated plunder. But it does show the slippery slope krinkles (cash) live under. Case in point TD's article showing it takes more zeuros proportionately to obtain physical. <--only way to own.

--The funny thing is I'm a po'ass dad just making it- sigh- Ag is what I can aspire to. Gold is for kings... Looks like a scant reside in the bowels of ZH, to which I aspire. Thanks to -most- here for enlightenment, humor, lessons learned by example without personal experience, and brutal honesty. Pimp slaps, too.

88% or 92% correlation? Interesting. Of course, 93.4% of all statistics are made up on the spot. But this paper I'm going to have to read, if only to check every so often. If this makes any sense at all it could be really valuable.

To make, first reheat old theories about elite organizations that supposedly control various world governments and would like to create a single, unitary, global regime—the Bilderberg Group, the Council of Foreign Relations, and the Trilateral Commission. Add a healthy portion of slightly newer but equally discredited theories about the Amero, a pan-North American currency, and the NAFTA superhighway, a planned thruway from Canada to Mexico said to be six football fields wide. Freshen with the economic-crisis-born idea that Ben Bernanke is trying to destroy the value of the dollar. Add a pinch of tea-party spice from former Alabama State Supreme Court Chief Justice Roy Moore, who believes there's a plan underfoot to have a United Nations guard at every American's door. The finished product should taste a little like this. Proponents:Alex Jones, finance blog Zero Hedge, WorldNetDaily, conservative news site NewsMax, Roy Moore. Kernel of Truth? Eh, sounds plausible to us.

This paper is a lot more worthwhile in determining the value of gold during a deflation. Its an inflationary trend paper, though it does show a chart with the calculation of the real value of gold since 1913. Note that during the depression, gold's real value was almost 30X the original price fix due to the massive wholesale decline of prices.

So what you are saying is the nominal value of gold was $35 per oz but those dollars it converted to had greater purchasing power in the deflation. Could not the same thing happen today without gold, you know, actually travelling to the moon in nominal terms?

La Jolla Bank, FSB, La Jolla, CA with approximately $3.8 billion in assets and approximately $2.8 billion in deposits was closed. OneWest Bank, FSB, Pasadena, CA has agreed to assume all deposits. (PR-034-2010)

George Washington Savings Bank, Orland Park, IL with approximately $412.8 million in assets and approximately $397.0 million in deposits was closed. FirstMerit Bank, N.A., Akron, OH has agreed to assume all deposits. (PR-033-2010)

The La Coste National Bank, La Coste, TX with approximately $53.9 million in assets and approximately $49.3 million in deposits was closed. Community National Bank, Hondo, TX has agreed to assume all deposits. (PR-032-2010)

Marco Community Bank, Marco Island, FL with approximately $119.6 million in assets and approximately $117.1 million in deposits was closed. Mutual of Omaha Bank, Omaha, NE has agreed to assume all deposits, excluding certain brokered deposits. (PR-031-2010)

I disagree with the premise that assets must have a "P/E" ratio or correlation on a linear analysis model that doesn't account for investor fear & panic for this most emotional asset. Another attempt by academics to design a "model" using the wrong concepts for an ever evolving market over time. From the same folks that brought you the "efficient markets" concept. Moreover, does anyone trade stocks on their P/E ratios or yield only? Rubbish...

What a silly discussion this is, if we look at the gold, it's just a metal but it has very important characteristic, nobody knows how to counterfeit it and its supply grows at the pace of population growth. Goverment of USA tried to highjack that property guaranteeing exchange rate to USD but shortly decided it's not possible because their needs were much higher than gold standard allowed them to spend. So this is very important characteristic which is very hard to find with other stuff. You like paper that's ok with me, our predecesors did not like that idea but you are much smarter than barbarians, you are enchanted with it's magic power to muliply by using interest. Who cares what the real value of gold is, it's just comparison tool for value of services or products, and because of limited supply it's not going to go crazy. What value has US paper dollar? Paper value+green stuff on it+US goverment word? What if we have rogue President who says "we don't have enough money, lets print it"? At least with gold you cannot do it, I know it's good for Americans because if they are short of money they print them, but why Greece cannot do the same? Because world trade is in USD and enforced by military might, who wants Greek drachma, you or me I don't think so. The moment international trade changes from USD to whatever, my preference is my new currency Doo-Doo's, finally my retirement problems would be solved, USA ids doomed, why? Just think about it.

The paper acknowledges the decreasing proportion of total wealth accounted for by gold, as opposed to paper assets like stocks, bonds, etc. But the paper fails to account for psychological factors. When people have faith in their government, the stability of their country, world peace, their currency, the integrity of their financial markets (stocks and bonds), like we did in the US in the 1990s, paper assets soar and gold flounders. When people lose faith or confidence in their country, or currency, or stocks, or bonds, people flock to traditional stores of value such as gold. Like now.

Countries like the US, Japan, and the Eurozone seem to be mathematically unable to balance their budgets without enormous social strife, and hence are putting themselves in a position where servicing the debt will become impossible in the not too distant future without some creative financial solutions.

Hence gold has been alternatively been hitting new highs in Euros or US Dollars recently. If a conversion of just a fraction of paper wealth in the G7 into precious metals occurs as confidence is lost the price of gold will continue to hit new highs. I would argue gold should be valued as some fraction of total world money and debt, and probably should be about 10,000 per ounce.

However, with the worldwide depression, the buying power of money has actually been increasing for those who have it, so that has tempered the rise in gold, in spite of the fact that the financial systems and currencies look increasingly fraudulent.

One must also point out that people in a country who fear collapse or ruin or disintegration will of course convert their currency into something else, either other currencies, other bonds, other stocks, or gold. For example, if you're a rich Saudi Arabian and you fear that someone, say, Iran, is looking to literally destroy your country, you might be inclined to convert much of your assets into something else.

Because if a country fails, or is conquered, its currency, bonds, and stocks in its corporations are worth what? Little or nothing?

Gold actually hit its most recent lows in the late 1990s when the US reigned supreme, the cold war was over, the US Dollar was king, our economy was humming, our budget was sort of balanced, and stocks world wide were soaring. Also, interest rates yielded a decent return.

Now, in the span of a decade, its all unravelled. China is rising, the G7 is faced with depression and unserviceable debt, stocks have floundered for 10 years, bonds yield nothing, the US Dollar is a joke, as are most other currencies.

Sure, they might be sucking me in to cut off my knee caps with a gold price collapse, but I'm willing to put some of my assets into precious metals. Call it insurance.

Yes in deed , gold is a response to fear or lack of confidence in your political 'leaders' , and uncertainty and its more stabilizing influence as a store of value. Quantifying the element of fear and uncertainty can perhaps be done buy looking at spikes during political hot events???

Which is why it is accurate to identify someone as wise and prescient who accumulated in good times at low prices, someone as observant and teachable who accumulates at a higher price at the signs of pressure, and someone as foolhardy and negligent who mocks and denigrates insurance until the last moment and desperately attempts to accumulate in a parabolic uptrend.

Basing the price on population would infer that the asset in question (gold) is somewhat equally dispersed. Nor is debt based deflation and the smoking hole where "other financial assets" discussed in present context.

Some forms of currency are several thousand years old, and some forms are only a few hundred. The former is most certainly limited in supply, the latter is only limited by the click of a mouse.

There are too many bills and too much debt to pay not to see that option B is much less work than option A. Currency devaluation is inevitable along with more taxes and eventually death for us all. It's that simple.

If you're still at the table gambling when the house runs out of "cash" to make your chips pay out -you lose anyway. Regardless of what you think happened at the table.

Ask yourself, why are money market accounts that so many of us trade in/out, no longer necessarily immediately redeemable when you want to turn your ETF casino chips into "cash"?

Ask yourself, why did Citi announce today that they now
are reserving the right to require 7 days advanced notice
on a checking account. Yep. Your money on demand:

Our bets are placed, and now we wait for the house to fold
Patience and preparation is now the name of the game
The realization that we have hit peak oil will be the finisher
Long Au
Long Ag
Long CH4 complex chains

I don't think gold can be equated to a PE of any sort. The paper is interesting but basically bunk. Gold is only of interest to investors when paper money doesn't provide a positive rate of return over inflation. Negative returns on cash means money exits paper currencies. Thus, the value of gold is inversely related to the volume of paper currency in circulation and the number of people trying to get rid of it. It's safe to say that the fair value of gold is higher than the present price.

This is a load of BS. I use the suit algorithm. An ounce of gold= one decent, new Armani Exchange suit. It was like this when I bought a suit for a wedding in the 90's and it works now. And that Greek dude probably liked Italian suits as well.
In seriousness, it's close but this article is great info. Thanks

If things don't get too bad, I would think gold will stay related to the amount of money (cash and credit) in the system and GDP.

Real things, having real value (see Zimbabwe: http://www.youtube.com/watch?v=7ubJp6rmUYM).
Plus, there is a real cost to get gold out of the ground, refine it and mint it (maybe around $300-400./oz.) which should create a floor for prices. Where electronic (FED) fiat IOUs or credit IOUs cost nothing to create (a few clicks on the magic FED keyboard or a swipe of your credit card).

In an economic collapse, gold is way down on my list of needs. Even in it's barter role, an oz of gold may have too much value for everyday transactions (I prefer silver for that role). I still maintain, gold is for optimists.

I agree gold is money (even in Zimbabwe they accept gold for bread measured in grams of gold dust see the video I linked to) Let's say you were currently in Zimbabwe, would you trade your oz of gold for a few quadrillion Zimbabwe dollars? Or trade it for 100 acres of farm land from some local warlord? Or more likely give it to someone who could get you safely out of there.

If you are optimistic about the coming economic collapse, there will be rule of law, coin shops to trade your gold for the fiat currency of the day, grocery stores to spend fiat currency in, etc.. I guess I am not that optimistic. Gold and silver will preserve wealth in most situations, but in a "black swan" economic collapse, I prefer bullets and beans to bullion.

refine it and mint it (maybe around $300-400./oz.) which should create a floor for prices.

sorry, its higher than that. thats just the lift cost once the mine is already in existence and past commissioning. add in the costs of leasing land, permits, enviro studies, mapping, trenching, drilling, NIE's, PEA's... - its a lot higher than 300-400.

Let me preface my comment with, "I love gold and wish I had more." Now, after saying that, this paper is NOT scientific. What a load of crap. Good thing they are not in my grad school class. How about the simple fact, gold is worth what people are paying for it.

I think what they are saying is that the price of gold is correlated with the reciprocal of the P/E ratio of the S&P. I was never good at deciphering economists' math. There are always 15 variables or more in a given equation. It took me until eq 8 to realize that the previous equations were difference equations.

Somebody could run a spreadsheet on the S&P "E/P" ratio and see how well it correlates to gold. I can't tell if they are just doing a correlation analysis without looking for an underlying causal factor. I don't understand their underlying theory, assuming the causal factor lies there.

Someone had previously pointed out that gold does well when real interest rates--as opposed to nominal interest rates--are negative.

Although I love gold, the metal, I can't understand why people fuss so much about an asset that has gone from about $300 per ounce to $1000 an ounce in 10 years. Is this such a spectacular return? Aren't there better ways to invest money?

In normal circumstances, you would, of course, be correct. But remember this; current gold investors are looking at the next ten years, not the last ten. We are past return on capital and forward looking at return of capital. Waking up more or less intact in 2012 is the next success story for those of us who will not be attending bilderberg this year (and maybe them as well)

Captain Kirk, the cliff notes for this would read
"buy gold now"
Also,shields should be up and the phaser banks fully
charged. Spare, tested, di-lithium crystals on the shelf
The Fed is attacking, and the Fed is cloaked....

"In the absence of a gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good and thereafter decline to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as claims on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to be able to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard." --- Alan Greenspan, 'Gold and Economic Freedom' (1966).

"Governments can achieve a welfare gain roughly equal to that from an immediate sale through alternative policies. One such policy is specified in the bottom panel of Chart 5. Under this alternative policy, governments loan out all their remaining gold in each period. In the future when all gold now owned by private agents, whether above or below ground, has been used up, governments sell in every period whatever gold is necessary to make the price be what it would have been if they had sold all their gold immediately. The quantities of gold available for private uses are the same under the alternative policy as with an immediate sale. However, there is an important difference: under the alternative policy, governments relinquish title to their gold in the future and then only gradually. Therefore, to the extent that government uses can be satisfied by owning gold but not physically possessing it, most if not all of the gains associated with maximizing welfare from private uses can be obtained with little or no reduction in welfare from government uses until sometime in the future."

Please read the entire PDF for far more information. This is but one of quite a few government and Fed papers that may be quite revealing.

Maybe the most brazen admission of the Western central bank scheme to suppress the gold price was made by the head of the monetary and economic department of the Bank for International Settlements, William S. White, in a speech to a BIS conference in Basel, Switzerland, in June 2005.

There are five main purposes of central bank cooperation, White announced, and one of them is "the provision of international credits and joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful." White's speech is posted at GATA's Internet site:

By just looking at the domain, I must correct you. This is the horsetheives local 209 note on gold policies and not the government's. THE FED IS A PRIVATE CORPORATION. I will grant that the two are currently joined at the hips (insert flippant comment here), but never forget the difference.

My edit button works as well. I forgive you the added GATA reference since we support the same concept.

In a court case involving a serious automobile accident that involved a US citizen and a member of the Federal Reserve using the 'company' car, it was found th US citizen could not sue the US government because the Federal Reserve is a private company/entity. Thus the Federal Reserve could be sued of course, yet not the US government.

This article is positively laughable. All you need to read is these two lines:

the authors observe that gold is priced to yield a constant after-tax real return related to long-term productivity as defined by real long-term GDP/capita growth.

Our theory explains about 88% of actual $USD gold prices and 92% of actual gold returns on a quarterly basis, including the peak prices of gold, over the 1979-2002 period.

So what they're really saying is "we constructed a valuation model based on B school principles and treated gold like any other asset class. We did this only over a brief period of time that is an historical aberration; a global regime of fiat currencies, central banking, and falling interest rates in the dominant West. What we found is that, under these carefully defined and controlled circumstances, gold behaves like any other asset."

The fact that the article is sprinkled with "math" makes it all the more puerile.

Edit: This is the kind of short time-window thinking that is going to get Gen Xers run over. They've lived their entire adult lives in a credit bubble where these principles worked, and the paradigm shift is going to absolutely kill them.

I wish I had read your reply first, and saved myself some time in replying to this paper below.

You characterize it almost perfectly.

I would only add that it is an old leftover cake, with more frosting applied.

Gold diverged significantly from this 'model' in 2002. The price is market based, and participation from the public is still thin and selective, at least in the developed world. It is telling us something.

Listen or not. But the professors' paper is not tradable. That is the long and short of it.

Wow... As an puertorrican Gen Xer, I cannot concur more with this comment. I've always believed it in my heart. I try to explain what is happening nowadays to my friends and no one believes me. They tell me I'm crazy, wrong or a conspiracy theorist. Thanks for those well constructed words of wisdom.

I find your simple refutation of this piece commendable, sensible and even courageous given the generally opposing view hyperbole I usually see spewed on this site. The article is just another theory seeking validation through overly complex bafflegab. Flaws aside, if the authors really wanted to convince the masses they might learn something by spending a little time on Twitter. Brevity being the soul of wit, so they say.

would argue gold should be valued as some fraction of total world money and debt, and probably should be about 10,000 per ounce.
-------------
If the US owned all the gold, it would be easy to divide the number of printed dollars by the number of Oz.

What happens when the reserve currency is in one country and all the gold in spread out in other countries?

The goal is to be able to buy stuff with your gold. If I don't have gold or can't buy it because I was priced out of the market, I can just barter a service for another. For most people, it's more important to have a skill than to have gold nuggets.

If governments print their way out of this mess, gold will probably go up quite a bit but the irony is that MOST people on these blogs won't be bale to hold onto thei gold nuggets as the price increases because they will need to eat.

Only those who can protect their stash or not use it for a decade will win with increasing gold prices.

The not-so-scientific outcome of this scientific theory points to something so obvious that even my eight year old son could have thought it up. Having a larger population chasing something that is of limited quantity of course drives the price up, be it gold, food, stocks etc etc etc.

I thought that this article would give me the Holy Formula for gold price determination. Instead, a lot of drivel to come up with this obvious conclusion.

3. Need to hit the road? Take it with you. Not sure how it works at customs, but at least within the country, it's portable.

4. Worried about someone cooking the books? Being diluted? An earnings decline? Not with gold. What if some nut case starts WW III? Not a problem, gold will hold up just fine.

5. What if your bank or brokerage or the country is hit with some massive cyber attack or EMP attack and the electronic records are compromised? Well, that would suck for everyone, but, as a holder of physical metals (or cash even), you're ok.

If you sell to someone and you are not issued either a form 1099B or 8300, then the sale might not be reported to the IRS. But if your bank accounts show a significant and otherwise unexplainable increase, best of luck explaining that during any audit.

One thing I like to do is test someone on their knowledge of the basic property of gold, pointing out that its inert and does not oxidize. I also lay it on thick by saying that a millenium into the future, that same purified gold coin or bar will look exactly as it does now, without any change. The usual reaction is disbelief.

During the past few weeks of summer respite, I had been reading The House of Medici: It's Rise and Fall by Christopher Hibbert. Precious metals naturally take a relatively important part in the history of such an illustrious banking dynasty. The fiorino d'oro, or florin, was minted in 1252 at Florence. The florin was already internationally known and well respected during the fifteenth century. This coincides with the heyday of the Medici's as the most powerful banking and political family in Florence and possibly the wealthiest family in Europe during that time. Their wealth, combined with their passion for art, turn them into generous patrons of many Italian artists during that time. This effort fostered a period of proliferation of artistic achievement, later known as the Renaissance.
The florin is the focus of this article. It's a coin containing fifty-four grains of fine gold. The coin has the city's Latin name, Florentia, stamped on its reverse side and the city's emblem, lily, stamped on its obverse side. In terms of purchasing power, here is what the florin can buy in about 1430's:
A "handsome palazzo" can be bought for a thousand florins.
A maidservant costs about ten florins a year.
A man can live very comfortably with an income of 150 florins.
A "cashier" in the Medici bank is paid with forty florins a year.
An "apprentice" in the Medici bank earns twenty florins a year.
The Medici Palace was worth about five thousand florins.
One troy ounce in weight equals to 480 grains.
Assuming that gold has been remonetized and that gold's remonetized value is calculated in the manner proposed by Jason Hommel: equating current M3 value with current official US gold, one gets a value of approximately $35,000/oz (= $9 trillion divided by 261 million ounces; see Hommel's "I'm Insanely Bullish on Silver")
This is an outrageously high value for gold!
But consider first, a "handsome palazzo" can be bought for a thousand florins. One thousand florins has a gold content of 112.5 ounces (= [1000*54]/480). Remonitizing that amount of gold would equate to $3,937,500 (= 112.5*$35,000) of purchasing power today. Today's equivalent of handsome palaces ("palazzo" is the Italian for palace) would be luxury estate, which is usually defined in the real estate profession as single-family residences in excess of $1,000,000. But many would be in the range of several million dollars.
Ten florins, which was a maidservant's yearly salary back in the days of the Medici's, would equate to today's $39,375 (= {[10*54]/480}*$35,000). This roughly equals to CIA's estimate of US GDP per capita: $37,800.
Considering the IRS' highest income tax bracket in the recent years is in the range of $200,000 to $300,000, a man can certainly live very well with amount of gold contained in 150 florins. If remonetized, 150 gold florins would have the purchasing power of $590,625 (= {[150*54]/480}*$35,000).
The Medici Bank was considered the bank in the fifteenth century. It was the most profitable organization in the Europe during that time. Certainly the bank's cashiers and apprentices should be relatively well paid. An apprentice's 20 florins roughly correspond to $78,750 (= {[20*54]/480}*$35,000) today. Goldman Sachs, arguably the most prestigious investment bank on Wall Street today, pays its analysts $55,000. In addition, in good years the entry-level analysts of a typical Wall Street "bulge-bracket" firm can easily be rewarded with approximately $10,000 of bonus (as some of my friends who worked there informed me). This would add up to $65,000.
While I don't know what a typical Wall Street investment bank associate's annual salary is, I do know that top MBA programs are such banks' favorite recruiting destination. Therefore, the average starting salary of, say, a Harvard MBA, should be a fair proxy of an associate's first-year income. Since an associate is the next employment level of an entry-level analyst in an investment bank, an associate's salary should roughly reflect the Medici bank cashier's 40 florins annual salary. For the class of 2002, a Harvard MBA's median first year total compensation is $125,000. This amount approximates 40 florins current purchasing power of $157,500 (= {[40*54]/480}*$35,000).
Finally, the ultra-luxury real estate market routinely sells at $38 to $75 million dollars as reported by a recent Forbes survey of Most Expensive Homes in America. The price of Medici Palace, 5000 florins, represents today's purchasing power of $19,687,500 (= {[5000*54]/480}*$35,000). This is lower than the low-end of recent ultra-luxury estate price range. But considering the Medici's purposely built their main residence "far from grandiose" to avoid jealousy, this "undershooting" of purchasing power should not be surprising.
So, while some may have expressed objection at Hommel's projection of gold's remonetized value of $35,000 per ounce, such a price actually has some validity if one uses it as a proxy for comparing the purchasing power of gold between today and the Italian Renaissance. Put it the other way, if we were to go back to the tradition of using gold and silver as money, an ounce of gold can buy up to $35,000 of goods!
What does all this mean for silver?
Others can and have written better articles than I do on why silver is a better investment than gold, such as silver's supply deficit, industrial use, etc. But the bottom line is, there may exist less above ground inventory of silver than gold, thereby, making silver potentially more valuable than gold if both are monetized. Assuming GATA is right, which I think so, that the central banks have already leased out as much as half of its 30,000 tons of gold, which implies 15,000 tons, or roughly 480 million ounces, of gold remain in the Central Banks' vault. However, the above ground silver inventory is estimated at 200 million to 600 million ounces, with the average estimate at 400 million ounces. And due to silver's supply deficit, this 400-million ounce inventory is shrinking!
Do you see how silver can have the potential to exceed even gold's fabulous $35,000 per ounce projection?

FOFOA has his own probability price distribution curve, shaped like the normal distribution. The median is $55,000 / toz (non-hyperinflated 2009 dollars), the prices at 2 s.d. are something like $20,000 at the low end and $90,000 at the high end. Wooo hooo!

FOFOA is a rather dense read, but I have learned a lot about gold from him as well as here at ZH.

I agree with above posters that the short time window of validity casts a serious shadow over the formula. Why stop at 2002? And why not extend back to the 1700s using British data?

Another problem with this paper: the formula depends on GDP being a meaningful construct. It isn't, since production and consumption are intermingled. A little thought experiment (um, set consumption = 100%) reveals the formula to be problematic.